Fannie, Freddie set strict rules for rental income in real estate purchase

First-time homebuyers strapped for income have often looked to generate some rental income from the house they plan to purchase that will help them qualify for the mortgage. A common question:

Q: "I am looking to buy a property that I will occupy part of the year. The rest of the time it will be rented out for a guaranteed amount. Will the lender include the rental income in qualifying me for a loan?"

A: No. Under the rules established by Fannie Mae and Freddie Mac after the financial crisis, rental income can be included in qualifying income only as documented in the owner’s tax return for at least one year. That means that rental income cannot help you qualify for the mortgage used to purchase the house that will generate the income.

And it gets worse. Because the rent is guaranteed, your transaction will be classified as an "investment" rather than a purchase for "permanent occupancy." Investment loans have always been priced higher, but since the crisis the down payment requirement has also been raised. Where 5 percent down is acceptable today for a borrower with good credit who is purchasing for occupancy, the same borrower purchasing as an investment has to put 20 percent down.

Since rental income cannot help you qualify, it is foolish to purchase the house as an investment. The wiser course is to purchase it as your primary residence or second home. At some future time, you could reconsider the possibility of renting it.

I have to wonder whether Fannie and Freddie, in making it impossible to use rental income to help qualify for a purchase, realized that it would stimulate the future conversion of occupancy loans into investment loans without the borrowers paying investment-loan prices?

Move-up buyers who are selling an existing house to purchase a more expensive one are also thwarted by the existing rules.

Q: "I currently own a home that I plan to rent out when I purchase another home. Can I use the rental income on my first home to help me qualify for the second?"

A: Before the financial crisis, this was possible. The lender would assume that some part of the rental income (usually 75 percent) would remain after paying for utilities, maintenance, etc. The income remaining after subtracting the mortgage payment, taxes and insurance could be used to help qualify for the purchase.

But today rental income must be documented by a tax return for at least one year. That means that you have to rent out your current home for at least one year before the rental income will help you buy a new home. Where you would live in the meantime I am not sure.

A major reason the house-purchase market is in the doldrums is the virtual absence of move-up buyers. In large part this has been due to the loss of equity associated with home-price declines. Equity in their existing houses was the springboard for most move-up buyers because it enabled them to make a sizable down payment on the new house.

However, if not for the misguided change in rules regarding rental income, the loss of equity would be partially offset by move-up buyers electing to become landlords.

This is only one of many restrictive policy changes that are preventing a recovery of the housing market. I will have more to say about this in another article.

Jeopardize retirement to help the kids?

Q: "I am retired with a modest income and want to help my daughter and her husband buy a house. Their credit is poor, mine is excellent. Is there some way to substitute my credit for theirs? If necessary, I will buy the house for them by withdrawing the money from my retirement accounts."

A: The credit score that lenders use is the score of the person whose income is used to qualify. Your good credit won’t help them.

I advise against withdrawing money from retirement accounts to help children buy houses except for limited amounts to help fund a down payment. Buying a house for them could jeopardize your retirement, so consider it very carefully. Couples with financial habits that disqualify them from becoming homeowners are unlikely to improve their habits after dad buys a house for them.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.